June 3rd 2010

Japanese Yen: 90 or 95?

After a healthy appreciation against the Dollar in 2009, the Yen has backed off slightly in 2010, hovering around the level of 90 USD/JPY. Still, every time the Yen falls, traders quickly push it back up to 90. One has to wonder: Will the Yen ever fall?

Analysts attribute the Yen’s resilience to a series of aberrant developments, rather than to some kind of cohesive trend. Above all, there is the sovereign debt crisis in Europe, which has directed a steady stream of risk-averse capital to Japan. Under the existing paradigm, the US, Japan, Switzerland, a handful of other economies are still thought of as financial safe havens, a notion which serves to explain the Yen’s surge to a 10-year high against the Euro.

This is not exclusively a one-way trend. On the contrary, there is a constant ebb and flow in risk-tolerance as investors weigh the seriousness of the EU debt debacle and other crises. In fact, some believe that the recent uptick in risk aversion is already in decline: “Once investors shift their attention back to the fundamentals, which are still signaling solid improvement, there is no strong reason to buy the yen. Underlying demand for higher-yielding assets outside Japan remains strong.”

Outside of this, there is also some debate as to what constitutes a safe-haven currency, and whether the Yen qualifies. On the one hand, Japanese interest rates are extremely low and monetary policy remains accommodative. It’s capital markets are deep (though not exactly buoyant), and for investors that value capital preservation, Japan would seem like a reasonable choice. On the other hand, this mentality is facing a backlash as a result of prolonged political uncertainty. Since unseating the Liberal Democratic Party in 2009 – an historic achievement – the Democratic Party has been in a dither and implemented no new, meaningful policies. The finance minister was replaced a few months ago, and to top it off, the Prime Minister himself is set to resign.

It is both the uncertainty – the perennial enemy of the carry trade – and the potential replacement which worries investors and currency traders. The current front-runner, Finance Minister Naoto Kan, has not made a secret of his desire for a weak Yen: “Markets in principle should determine foreign exchange rates, but I think we must closely watch [markets] and ensure that there won’t be any excessive yen rises.” As Prime Minister, he would probably be more aggressive than his predecessor in intervening in currency markets, if need be.

Perhaps with Mr. Kan’s support, the Central Bank of Japan recently announced that it would inject $20 Billion into capital markets as part of of an effort to “calm” the financial markets. The Central Bank is apparently committed to “combating deflation,” which in some circles is code for currency devaluation.

In short, the only real question – posed in the title of this post – is the exchange rate that the Japanese leadership is targeting. Currency valuation is always more art than science, so it’s unclear not only the rate that in reality is fair, but also the rate that Japan perceives as fair. My feeling is that it’s north of 95 Yen/Dollar. It seems that anything between 90 and 95 is acceptable, while a drop below 90 is cause for intervention. For now, that intervention has been entirely vocal; if the government’s approval ratings remain in the basement, however, it could turn into actual intervention.